CoinShares Crypto Report: A Framework for Analyzing Crypto Assets

Many traditional investors are intrigued by cryptocurrencies, but it’s difficult to determine where to start and what trends to watch. While bitcoin has captured headlines with its meteoric price increase, there are more than 1,000 other cryptocurrencies with around 50 more initial coin offerings hitting the market each month.

Analyzing these cryptocurrencies can be incredibly challenging compared to conventional stocks, bonds, options, and futures. In our recently released H2 2017 Crypto Report, we take a look at the three critical components of crypto assets to assess initial and ongoing investment opportunities.

But before we recommend reading the Crypto Report, let’s start with a quick education on 3 core crypto-asset concepts to make sure we are all starting with the same knowledge base.

What is a Crypto Coin?

Cryptocurrencies are denominated in coins, most of which are mined as a part of the transaction verification process. Mining exists to prove loyalty to a system by requiring provably expensive input work in order to be allowed the privilege of verifying transactions (for which miners receive newly minted coins as a reward). As more and more miners compete for the freshly minted coins, the difficulty level automatically resets such that the block verification times always average out to the same length of time. More miners means a more secure protocol and an increased cost of “forging” coins by tampering with the transaction history.

Without diving into too much technical detail, mining normally involves the randomized task of looking for a number (nonce), such that when this number is hashed together with all the transaction data in a block, the generated hash comes out to be a number less than the current difficulty level. There is no way of predicting this result and there is no method more effective at finding it than guessing at random. The catch is that verifying the validity of the block containing this nonce is a trivial calculation, making valid blocks expensive to generate, but cheap to verify. Because miners are expending significant cost in creating them, they are incentivized to act in the best interest of the cryptocurrencies they are mining, by for example not allowing non-valid transactions, lest they render their reward devalued to their own detriment.

Traditional investors might conceptualize this as mining gold in a world where gold becomes increasingly difficult to mine as the remaining finite supply dwindles. Cryptocurrencies have the added advantage of being digital currencies that involve much lower transaction, transportation, or storage costs, making them more economical to transact than gold coins.

There are over 1,000 different cryptocurrencies, including popular names like Bitcoin, Ethereum, Litecoin, Dash, Monero, and Ripple. Each month, there around 50 initial coin offerings (ICOs) for new tokens that are introduced into the market. The sheer number of coins and tokens can make the asset class intimidating to those that aren’t familiar with the ins and outs of the industry, which is where this Crypto Report aims to be helpful.

What is a Crypto Exchange?

Cryptocurrencies are traded on various exchanges, which simply are online platforms that enable a person to exchange one cryptocurrency for another cryptocurrency or fiat currency.

One could think of these exchanges like traditional stock exchanges, currency exchanges, or brokers, but they aren’t typically regulated by governments or insured in any way. This means that investors must ensure that they’re doing business with an exchange that is secure and reputable with reasonable fees in terms of both commissions and spreads. In addition, they must make sure that the exchange offers all of the products and features that they require.

The importance of working with a reputable exchange is underscored by the failure of Mt. Gox in the early days of Bitcoin. After launching in July 2010, the Mt. Gox exchange was responsible for over 70% of all bitcoin transactions worldwide by 2013 and 2014. But in February 2014, the exchange announced that about 850,000 bitcoins worth more than $450 million at the time were “missing”, leading to their subsequent bankruptcy and liquidation. Clients have still not regained any funds.

Some of the most important factors to consider when evaluating a cryptocurrency exchange include:

Funding Flows – Where is the money coming from?

Liquidity – How liquid is the exchange?

Currency Pairs – Do they only offer liquid coins or are they more adventurous?

Banking Relationships – Do they have any banking relationships and do these relationships make them susceptible to disruption if terminated?

History – Is the exchange credible and secure with a strong track record?

Regulations – Is the exchange regulated by any governments, or do they have self-imposed regulations?

What is a Crypto Network?

The cryptocurrency network represents the group of people using the coin, mining the coin, relaying and verifying transactions, and maintaining the underlying software. In addition to miners processing transactions, the network consists of nodes that broadcast and relay valid transactions across the network. These nodes must have a fully-functioning client with a complete blockchain to prevent problems like double spending (when a user tries to spend the same token twice).

Traditional investors should consider a cryptocurrency’s network characteristics for the same reason that they wouldn’t invest in a company just because of its market capitalization alone. An illiquid penny stock could have a large market capitalization, but that market capitalization is meaningless beyond pure speculation if there is no underlying business to support it. A cryptocurrency’s network can, to some degree, be compared to a company’s operations – it’s the true asset behind the hype.

Most cryptocurrency networks are impacted by network effects, which means that the value of the network increases as its number of users increases. In particular, Metcalfe’s law states that the cost of a network is directly proportional to its number of users, but the value of the network is proportional to the square of the number of users. This is partly why networks such as those of Bitcoin and Ethereum, who have a comparatively large user base, have built up significant barriers to competition.

The Crypto Report takes a look at some of the most important factors to consider when evaluating cryptocurrency networks, including:

Mining – What is required to mine the coins and who are the miners? What are the relative sizes of the mining networks between coins?

Creators – Who are the developers behind the cryptocurrency? How is new code created? What is the governance model?

Technology – What type of cryptography does the cryptocurrency rely upon? Is the technology experimental or established?

Value and Capability – Does the network allow for anything other than value transfer?Users – Who is using the cryptocurrency? Are there commercial companies funding it?

Funding – How does the network fund itself?

The Bottom Line

Investors have become increasingly interested in cryptocurrencies, but it can be (and is) overwhelming to analyze them from an investment standpoint. That’s why we have built a professional research arm to help investors understand the complex dynamics of cryptocurrencies and help them make better investment decisions. The Crypto Report is a twice-yearly publication that seeks to promote these goals.

Disclaimer

Coinshares (UK) Limited is an appointed representative of Sapia Partners LLP, which is authorised and regulated by the UK Financial Conduct Authority (FRN: 550103). This document has been prepared and issued by Coinshares (UK) Limited and is being provided for information purposes only. It is not intended as an offer or solicitation to enter into any proposed transaction or investment. Investors’ capital is at risk, and investors should only invest if they are able to afford the loss of all capital invested. There is no guarantee that the investment objectives will be achieved and past performance should not be construed as an indicator of future performance. Crypto-currencies can be extremely volatile and subject to rapid fluctuations in price, positively or negatively. Investment in one or more crypto-currencies may not be suitable for even a relatively experienced and affluent investor. Each potential investor must make their own informed decision in connection with any such investment (after having sought independent financial advice thereon).